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Unformatted text preview: C H A P T E R 10 Consumer Surplus and Dead Weight Loss This chapter brings together all the concepts from consumer theory and in the process illustrates the difference between (uncompensated) demand and marginal willingness to pay (or compensated demand). We already developed (uncompen- sated) demand in Chapter 9 where we brought our A , B and C points from the consumer diagram into a new graph that had quantity on the horizontal and price on the vertical axis. But we only used the A and C points with B playing no real role other than allowing us to see how big the substitution effect versus the income effect was. Compensated demand curves arise from compensated budgets, and thus we now turn our attention to point B . In particular, we see that the compensated demand curve connects A and B (rather than A and C ) and that this curve can also be viewed as our marginal willingness to pay curve. (The same distinction between compensated and uncompensated curves can be made for the supply curves that emerge from the worker and saver diagrams but we leave that until later (Chap- ter 19) in the text.) We then find that it is this marginal willingness to pay curve that we can use to measure consumer surplus and changes in consumer welfare, not the uncompensated demand curve from Chapter 9. The two curves are the same only in one very special case. Chapter Highlights The main points of the chapter are: 1. We can quantify in dollar terms the value people place on participating in a market and we define this as the consumer surplus . We can similarly quantify the value people place on either getting a lower price or having to accept a higher price. 2. To do this, we need to know the marginal willingness to pay for each of the goods a consumer consumes and this is closely related to the changing MRS along the indifference curve on which the consumer operates. 169 Consumer Surplus and Dead Weight Loss 3. The marginal willingness to pay is derived from a single indifference curve and thus incorporates only substitution effects . It is the same as the un- compensated demand curve only if there are no income effects only if tastes are quasilinear in the good we are modeling. 4. Price-distorting taxes (and subsidies) are inefficient in the consumer model to the extent to which they give rise to substitution effects . Therefore, the inefficiency goes away if the degree of substitutability between goods is zero. 5. The deadweight loss from taxes (or subsidies) can be measured as a distance in the consumer diagram or as an area along the marginal willingness to pay curve . 6. To say that a policy is inefficient is the same as to say that there exists in prin- ciple a way to compensate those who lose from the policy with the winnings from those who gain. That is not the same as saying that such a policy exists in practice....
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